Chapter 11/Measuring the Cost of Living197

24

MEASURING THE COST OF

LIVING

SOLUTIONS TO TEXT PROBLEMS:

Quick Quizzes
1. The consumer price index measures the overall cost of the goods and services
bought by a typical consumer. It is constructed by surveying consumers to
determine a basket of goods and services that the typical consumer buys. Prices
of these goods and services are used to compute the cost of the basket at
different times, and a base year is chosen. To compute the index, we divide the
cost of the market basket in the current year by the cost of the market basket in
the base year and multiply by 100.
The CPI is an imperfect measure of the cost of living because of (1) substitution
bias, (2) the introduction of new goods, and (3) unmeasured quality changes.
2. Since Henry Ford paid his workers $5 a day in 1914 and the consumer price index
was 10 in 1914 and 230 in 2012, then the Ford paycheck was worth $5 230 / 10
= $115 a day in 2012 dollars.
Questions for Review
1. A 10% increase in the price of chicken has a greater effect on the consumer price
index than a 10% increase in the price of caviar because chicken is a bigger part
of the average consumer's market basket.
2. The three problems in the consumer price index as a measure of the cost of living
are: (1) substitution bias, which arises because people substitute toward goods
that have become relatively less expensive; (2) the introduction of new goods,
which are not reflected quickly in the CPI; and (3) unmeasured quality change.
3. If the price of imported French wine rises, there is little effect on the consumer
price index, because alcoholic beverages account for only 1 percent of the CPI's
basket. But the GDP price index is not affected at all, because imported French
wine is not produced domestically so it is not included in GDP.
4. Because the overall price level doubled, but the price of the candy bar rose
sixfold, the real price (the price adjusted for inflation) of the candy bar tripled.
5. The nominal interest rate is the rate of interest paid on a loan in dollar terms. The
real interest rate is the rate of interest corrected for inflation. The real interest
rate is the nominal interest rate minus the rate of inflation.

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198Chapter 11/Measuring the Cost of Living

Quick Check Multiple Choice
1. c
2. b
3. d
4. a
5. d
6. d
Problems and Applications
1. Answers will vary. Students should multiply $100 by the CPI for the year in which
they were born and then divide by 100.
2. a. Find the price of one unit of each good in each year:
Year
2013
2014

Cauliflow
er
$2
$3

Broccoli

Carrots

$1.50
$1.50

$0.10
$0.20

b. If 2013 is the base year, the market basket used to compute the CPI is 100
heads of cauliflower, 50 bunches of broccoli, and 500 carrots. We must now
calculate the cost of the market basket in each year:
2013: (100 $2) + (50 $1.50) + (500 $0.10) = $325
2014: (100 $3) + (50 $1.50) + (500 $0.20) = $475
year:

Then, using 2013 as the base year, we can compute the CPI in each
2013: $325/$325 100 = 100
2014: $475/$325 100 = 146

c. We can use the CPI to compute the inflation rate for 2014:
(146 100)/100 100 = 46%
3. a. The percentage change in the price of tennis balls is ($2 $2)/$2 100 = 0%.
The percentage change in the price of golf balls is ($6 $4)/$4 100 = 50%.
The percentage change in the price of Gatorade is ($2 $1)/$1 100 =
100%.
b. The cost of the market basket in 2014 is (100 x $2) + (100 x $4) + (200 x $1)
= $800.
The cost of the market basket in 2015 is (100 x $2) + (100 x $6) + (200 x $2)
= $1,200.
Using 2014 as the base year, we can compute the CPI in each year:
2014 = ($800/$800) x 100 = 100
2015 = ($1,200/$800) x 100 = 150
We can use the CPI values to compute the percentage change in the overall
price level:
(150-100)/100 x 100 = 50%.

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Chapter 11/Measuring the Cost of Living199

c. This would lower my estimation of the inflation rate because the value of a
bottle of Gatorade is now greater than before. The comparison should be
made on a per-ounce basis.
d. More flavors enhance consumers well-being. Thus, this would be considered a
change in quality and would also lower my estimate of the inflation rate.
4. Answers will vary.
5. a. The cost of the market basket in 2014 is (1 $40) + (3 $10) = $70.
The cost of the market basket in 2015 is (1 $60) + (3 $12) = $96.
Using 2014 as the base year, we can compute the CPI in each year:
2014: $70/$70 100 = 100
2015: $96/$70 100 = 137.14
We can use the CPI to compute the inflation rate for 2015:
(137.14 100)/100 100 = 37.14%
b. Nominal GDP for 2014 = (10 $40) + (30 $10) = $400 + $300 = $700.
Nominal GDP for 2015 = (12 $60) + (50 $12) = $720 + $600 = $1,320.
Real GDP for 2014 = (10 $40) + (30 $10) = $400 + $300 = $700.
Real GDP for 2015 = (12 $40) + (50 $10) = $480 + $500 = $980.
The GDP deflator for 2014 = ($700/$700) 100 = 100.
The GDP deflator for 2015 = ($1,320/$980) 100 = 134.69.
The rate of inflation for 2015 = (134.69 100)/100 100 = 34.69%.
c. No, it is not the same. The rate of inflation calculated by the CPI holds the
basket of goods and services constant, while the GDP deflator allows it to
change and holds the prices constant.
6. a. introduction of new goods; b. unmeasured quality change; c. substitution bias;
d. unmeasured quality change; e. substitution bias
7. a. ($2.00 $0.15)/$0.15 100 = 1,233%.
b. ($23.09 $3.36)/$3.36 100 = 587%.
c. In 1970: $0.15/($3.36/60) = 2.7 minutes. In 2011: $2.00/($23.09/60) = 5.2
minutes.
d. Workers' purchasing power in terms of newspapers fell.
8. a. If the elderly consume the same market basket as other people, Social
Security would provide the elderly with an improvement in their standard of
living each year because the CPI overstates inflation and Social Security
payments are tied to the CPI.

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200Chapter 11/Measuring the Cost of Living

b. Because the elderly consume more health care than younger people do, and
because health care costs have risen faster than overall inflation, it is possible
that the elderly are worse off. To investigate this, you would need to put
together a market basket for the elderly, which would have a higher weight on
health care. You would then compare the rise in the cost of the "elderly"
basket with that of the general basket for CPI.
9. a. When inflation is higher than was expected, the real interest rate is lower than
expected. For example, suppose the market equilibrium has an expected real
interest rate of 3% and people expect inflation to be 4%, so the nominal
interest rate is 7%. If inflation turns out to be 5%, the real interest rate is 7%
minus 5% equals 2%, which is less than the 3% that was expected.
b. Because the real interest rate is lower than was expected, the lender loses
and the borrower gains. The borrower is repaying the loan with dollars that are
worth less than was expected.
c. Homeowners in the 1970s who had fixed-rate mortgages from the 1960s
benefited from the unexpected inflation, while the banks that made the
mortgage loans were harmed.

2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.